*2.3.1 Pillar I or minimum capital requirement (MCR)*

Pillar I or MCR states that banks are required to maintain regulatory capital that is 8% of risk-weighted assets (RWA). The RWA refer to the total assets of the bank that are risk-adjusted or weighted against credit risk, market risk, and operational risk according to the risk grade. Bank assets consist of cash, investment in securities, loans to governments, and businesses individuals that bear different risk characteristics. Therefore, risk weight is assigned to this asset group to indicate the level of riskiness in each asset group. To calculate the capital requirement, it takes into account both the on-balance sheet and off-balance sheet items of the bank.

Eligible regulatory capital is constituent of core capital or **Tier 1 capital** and supplementary capital or **Tier 2 capital**. Pillar I states the maintenance of regulatory capital on these two types. Core capital is the equity capital of the bank, retained earnings, and other reserves. For supervisory purposes, the committee determined to present the capital of the bank in two groups Tier 1 and Tier 2 where Tier 1 or the core capital should not be less than 50% of the total capital base of the bank that consists of common equity and approved reserves from the retained earnings. Other elements of the capital will have to be grouped in Tier 2 that is limited to 100% of the core capital or Tier 1 capital. Tier 2 includes the following:


Short-term subordinated debt covering market risk or **Tier 3 capital**. Even though the eligible regulatory capital consists of core capital and supplementary capital, to cover the market risk, bank at its discretion can build Tier 3 capital that consists of short-term subordinated debt. This Tier 3 capital base can be built to support solely the market risk and cannot be higher than 250% of the core capital or Tier 1 capital.

The items to be deducted from the capital base are goodwill (deduction from Tier 1 capital), increase in equity due to securitization exposure, and investment in subsidiaries performing in the banking and financial sector that is not included in the national system.

Minimum capital requirement (MCR) is calculated for credit risk, market risk, and operational risk. BCBS advises that the minimum capital requirement under Basel II must be 8%, which will be calculated as follows: CAR = \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ *Tier* <sup>1</sup> <sup>+</sup> *Tier* <sup>2</sup> <sup>−</sup> *Deductions* <sup>+</sup> *Tier*3 *Cr risk RWA* <sup>+</sup> *Oper risk RWA* <sup>+</sup> *Mkt risk RWA* ≥ 8% (1)

$$\text{CAR} = \frac{\text{Tier 1} + \text{Tier 2} - \text{Deductions} \star \text{Tier3}}{\text{Cr risk RWA} + \text{Open risk RWA} + \text{Mkt risk RWA}} \cong \\$\\$\text{\\$}\tag{1}$$

**7**

*Capital Adequacy Regulation*

*2.3.1.1 Credit risk*

and credibility.

specific provision.

*2.3.1.2 Operational risk*

sheet items.

*DOI: http://dx.doi.org/10.5772/intechopen.92178*

the approval of the supervisors [5].

Risk-weighted asset for credit risk is calculated for credit RWA for exposure in banking book except the counterparty credit risk arising from equity investment, securitization exposure, and trading book instruments. Bank can choose either standardized approach (SA) or internal ratings-based approach (IRBA) to calculate their capital requirement against credit risk. In standard approach the risk is measured by the support of external rating or credit assessments whereas internal rating based approach is conducted by banks internal rating system and subject to

In case of standardized approach, claims against different counterparties are risk weighted against their rating. This credit rating is assessed by external credit rating institutions. In case of absence of any credit rating, the banks are advised to follow the instruction by the regulatory authorities. National regulatory or supervisory authorities permit the eligibility of the external credit assessment institution upon fulfillment of certain conditions. The credit rating agency must fulfill six criteria: objectivity, independence, international access/transparency, disclosure, resource,

BCBS advises risk weight for claims on sovereigns, non-central government public sector entities, multilateral development banks, banks, securities firms, corporates, included in the regulatory retail portfolios, secured by residential property, commercial real estate, past due loans, and off-balance sheet items. A higher credit score signifies lower risk weight in calculating the risk-weighted asset of the bank. In standardized approach, bank calculates the total risk-weighted asset of the bank taking into consideration the whole credit portfolio. Along with the regular claims, the unsecured loans that are past due for more than 90 days are also risk weighted. This unsecured portion of the loan is risk weighted after the net of

In standardized approach, the off-balance sheet items are converted into credit exposure equivalents through the use of credit conversion factors (CCF). The original maturity time determines the CCF of different commitments in the off-balance

Internal ratings-based approach (IRB) as its name implies relies on own estimates

of risk measurement in determining the capital requirement against credit risk, which are subject to fulfillment of certain conditions as well as disclosure requirements by the regulatory authorities. In IRB, the risk management team identifies the probability of default (PD), loss given default (LGD), the exposure at default (EAD), and effective maturity (M). Through these risk components, banks measure the unexpected loss (UL) and expected loss (EL). The capital requirements are calculated on the basis of unexpected loss. Expected losses are treated separately [5].

BCBS defines operational risk as "the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events." It includes the legal risk and excludes strategic and reputational risk. The committee advises three measurement approaches to calculate the capital charge against the operational risk of the bank. The approaches are (i) the basic indicator approach (BIA), (ii) standardized

Banks are encouraged to follow the sequential order of the measurement approaches. The level of sophisticated risk measurement system and practice would decide to follow the later approaches, i.e., standardized approach and advanced measurement approach. Internationally active banks with significant risk exposure

approach (SA), and (iii) advanced measurement approach (AMA).

where CAR is the capital adequacy ratio, Tier 1 is the Tier 1 capital, Tier 2 is the Tier 2 capital, Tier 3 is the Tier 3 capital, Cr risk RWA is the risk-weighted asset for credit risk, Oper risk RWA is the risk-weighted asset for operational risk, and Mkt risk RWA is the risk-weighted asset for market risk.

The following sections present a brief discussion on calculation of capital requirements for these risk areas, i.e., credit risk, operational risk, and market risk.

### *2.3.1.1 Credit risk*

*Banking and Finance*

items of the bank.

*2.3.1 Pillar I or minimum capital requirement (MCR)*

Pillar I or MCR states that banks are required to maintain regulatory capital that is 8% of risk-weighted assets (RWA). The RWA refer to the total assets of the bank that are risk-adjusted or weighted against credit risk, market risk, and operational risk according to the risk grade. Bank assets consist of cash, investment in securities, loans to governments, and businesses individuals that bear different risk characteristics. Therefore, risk weight is assigned to this asset group to indicate the level of riskiness in each asset group. To calculate the capital requirement, it takes into account both the on-balance sheet and off-balance sheet

Eligible regulatory capital is constituent of core capital or **Tier 1 capital** and supplementary capital or **Tier 2 capital**. Pillar I states the maintenance of regulatory capital on these two types. Core capital is the equity capital of the bank, retained earnings, and other reserves. For supervisory purposes, the committee determined to present the capital of the bank in two groups Tier 1 and Tier 2 where Tier 1 or the core capital should not be less than 50% of the total capital base of the bank that consists of common equity and approved reserves from the retained earnings. Other elements of the capital will have to be grouped in Tier 2 that is limited to

Short-term subordinated debt covering market risk or **Tier 3 capital**. Even though the eligible regulatory capital consists of core capital and supplementary capital, to cover the market risk, bank at its discretion can build Tier 3 capital that consists of short-term subordinated debt. This Tier 3 capital base can be built to support solely the market risk and cannot be higher than 250% of the core capital or

The items to be deducted from the capital base are goodwill (deduction from Tier 1 capital), increase in equity due to securitization exposure, and investment in subsidiaries performing in the banking and financial sector that is not included in

Minimum capital requirement (MCR) is calculated for credit risk, market risk, and operational risk. BCBS advises that the minimum capital requirement under

where CAR is the capital adequacy ratio, Tier 1 is the Tier 1 capital, Tier 2 is the Tier 2 capital, Tier 3 is the Tier 3 capital, Cr risk RWA is the risk-weighted asset for credit risk, Oper risk RWA is the risk-weighted asset for operational risk, and

The following sections present a brief discussion on calculation of capital requirements for these risk areas, i.e., credit risk, operational risk, and market risk.

CAR = \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ *Tier* <sup>1</sup> <sup>+</sup> *Tier* <sup>2</sup> <sup>−</sup> *Deductions* <sup>+</sup> *Tier*3 *Cr risk RWA* <sup>+</sup> *Oper risk RWA* <sup>+</sup> *Mkt risk RWA* ≥ 8% (1)

100% of the core capital or Tier 1 capital. Tier 2 includes the following:

• Undisclosed reserve or unpublished reserves

• General provision/general loan-loss reserves

Basel II must be 8%, which will be calculated as follows:

Mkt risk RWA is the risk-weighted asset for market risk.

• Revaluation reserve of certain assets

• Hybrid debt capital instrument

• Subordinated term debt

Tier 1 capital.

the national system.

**6**

Risk-weighted asset for credit risk is calculated for credit RWA for exposure in banking book except the counterparty credit risk arising from equity investment, securitization exposure, and trading book instruments. Bank can choose either standardized approach (SA) or internal ratings-based approach (IRBA) to calculate their capital requirement against credit risk. In standard approach the risk is measured by the support of external rating or credit assessments whereas internal rating based approach is conducted by banks internal rating system and subject to the approval of the supervisors [5].

In case of standardized approach, claims against different counterparties are risk weighted against their rating. This credit rating is assessed by external credit rating institutions. In case of absence of any credit rating, the banks are advised to follow the instruction by the regulatory authorities. National regulatory or supervisory authorities permit the eligibility of the external credit assessment institution upon fulfillment of certain conditions. The credit rating agency must fulfill six criteria: objectivity, independence, international access/transparency, disclosure, resource, and credibility.

BCBS advises risk weight for claims on sovereigns, non-central government public sector entities, multilateral development banks, banks, securities firms, corporates, included in the regulatory retail portfolios, secured by residential property, commercial real estate, past due loans, and off-balance sheet items. A higher credit score signifies lower risk weight in calculating the risk-weighted asset of the bank. In standardized approach, bank calculates the total risk-weighted asset of the bank taking into consideration the whole credit portfolio. Along with the regular claims, the unsecured loans that are past due for more than 90 days are also risk weighted. This unsecured portion of the loan is risk weighted after the net of specific provision.

In standardized approach, the off-balance sheet items are converted into credit exposure equivalents through the use of credit conversion factors (CCF). The original maturity time determines the CCF of different commitments in the off-balance sheet items.

Internal ratings-based approach (IRB) as its name implies relies on own estimates of risk measurement in determining the capital requirement against credit risk, which are subject to fulfillment of certain conditions as well as disclosure requirements by the regulatory authorities. In IRB, the risk management team identifies the probability of default (PD), loss given default (LGD), the exposure at default (EAD), and effective maturity (M). Through these risk components, banks measure the unexpected loss (UL) and expected loss (EL). The capital requirements are calculated on the basis of unexpected loss. Expected losses are treated separately [5].

#### *2.3.1.2 Operational risk*

BCBS defines operational risk as "the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events." It includes the legal risk and excludes strategic and reputational risk. The committee advises three measurement approaches to calculate the capital charge against the operational risk of the bank. The approaches are (i) the basic indicator approach (BIA), (ii) standardized approach (SA), and (iii) advanced measurement approach (AMA).

Banks are encouraged to follow the sequential order of the measurement approaches. The level of sophisticated risk measurement system and practice would decide to follow the later approaches, i.e., standardized approach and advanced measurement approach. Internationally active banks with significant risk exposure

in the operational areas are permitted to follow the standardized or advanced measurement approach.

In basic indicator approach, the capital charge for operational risk is equal to the 15% of average positive annual gross income of the bank. Gross income is the total of net interest income and net non-interest income. It does not include any realized profit or loss from the sale of securities and any income derived from insurance. The calculation of capital charge in basic indicator approach is as follows:

$$\mathbf{K}\_{\rm BIA} = \left[ \Sigma \langle \mathbf{G} \mathbf{I}\_{1\ldots n} \times \mathbf{a} \rangle \right] / \mathbf{n} \tag{2}$$

Here KBIA is the capital charge in basic indicator approach; GI is the gross income, which was positive, over the previous 3 years; n is the number of previous 3 years for which gross income is positive; and α is 15% required capital level against the operational risk.

In standardized approach, a bank's activities are divided into eight sectors: corporate finance, trading and sales, retail banking, commercial banking, payment and settlement, agency services, asset management, and retail brokerage. In standardized approach, for every sector separate gross income is calculated separately. To measure the capital charge, this sectoral gross income is multiplied by denoted beta (a factor). Beta is a proxy variable that denotes relationship between the operational risk (of loss) for the particular business sector and aggregate level of gross income for that business sector [5]. Unlike basic indicator approach, standardized approach measures capital charge for each business line separately.

In SA, capital charge is calculated by taking the 3 years average of simple summation of the regulatory capital charge for each of the business sectors. Any negative capital charge due to negative gross income for any business sector may offset the positive capital charge in other business sector without limit. If the aggregate capital charge across all business lines in a certain time period is negative, then the numerator will be considered as zero. BCBS expressed the equation as follows:

$$\mathbf{K\_{SA}} = \left\{ \Sigma\_{\text{Years1-3}} \max \left[ \Sigma(\text{GI\_{1-8} X \,\beta\_{1-8}}), \mathbf{0} \right] \right\} / \mathbf{3} \tag{3}$$

**9**

regulations.

*2.3.3 Pillar III or market discipline*

authority as well as public for comparison and credibility.

*Capital Adequacy Regulation*

sory authority.

*2.3.1.3 Market risk*

*DOI: http://dx.doi.org/10.5772/intechopen.92178*

In advanced measurement approach, banks use some qualitative and quantitative criteria to calculate the risk exposure and capital charge by their own. This approach requires complex modeling and is subject to the approval of the supervi-

BCBC defines market risk as "the risk of losses in on- and off-balance sheet positions arising from movements in market prices." Sources of market risk are interest rate risk, foreign exchange risk, and commodities risk [5]. Interest risk arises from the loss due to movement of interest rate. Foreign exchange risk arises from changes in banks' assets and liability due to the fluctuation of foreign exchange rate. In the case of cross-border investments, when banks invest in different currencies risk arises due to adverse changes in the exchange rate. Similarly, commodity risk arises

Market risk is measured using the standardized measurement method and value at risk (VaR) or internal model approach. The choice of method is subject to the permission of the regulatory authorities. In standardized measurement method, four risks are addressed which are interest rate, equity position, foreign exchange, and commodities risk. The practice of internal model approach is subject to compli-

Therefore, bank's total minimum capital requirement will be the summation of the capital requirement against the credit risk, capital charge for operational risk,

Pillar II or supervisory review process intends to assure that the bank has sufficient capital to support different risks arising in the business operation as well as encourage developing and practicing better risk management technique. SRP concedes the bank management to set capital target through developing an Internal Capital Assessment Process (ICAAP) that commensurate with banks own risk profile [5]. It also ensures that the bank management bears the responsibility to maintain the adequate level of capital beyond the minimum level to support its risk. The committee identifies the appropriate relationship between the risk and amount of capital and the effectiveness of bank's internal control and risk management process. The role of supervisory authority is to evaluate how the operating banks are assessing their risk and capital requirement and intervene if necessary. SRP intends to intervene the bank regulators to prevent capital shortfall from the minimum level in the early stage and to take rapid corrective action [5]. The SRP takes into account other risk factors that are not considered in Pillar I (i.e., liquidity risk and interest risk). The regulatory authority evaluates the bank's assessment of capital, ability to monitor, and be compliant with the capital

Pillar III promotes market discipline through a set of qualitative and quantitative disclosure requirements that allow the market participants to understand the scope of application, capital position, risk exposure, and assessment of the banks. It is complement to Pillars I and II. Therefore, the disclosure allows a bank to present its risk position that is based on a common and consistent framework to the regulatory

from the uncertain future market price changes in commodity prices.

ance of certain conditions and approval of the supervisory authorities.

and capital charge for market risk of the bank.

*2.3.2 Pillar II or supervisory review process (SRP)*

where KSA is the capital charge under the standardized approach; GI1–8 is the annual gross income in a given year, for each of the eight business sectors; and β1–8 is a fixed percentage, set by the BCBS, the level of required capital to the level of the gross income for each of the eight business sectors.

**Table 1** presents the value of β for each business sector as prescribed by BCBS [5] as follows.


**Table 1.** *Value of β for different business sectors.*

#### *Capital Adequacy Regulation DOI: http://dx.doi.org/10.5772/intechopen.92178*

In advanced measurement approach, banks use some qualitative and quantitative criteria to calculate the risk exposure and capital charge by their own. This approach requires complex modeling and is subject to the approval of the supervisory authority.
